Sources of Tax-Free Income

Though most income and compensation is subject to federal taxes, not all it is. J.K. Lasser, whose “Your Income Tax” (John Wiley & Sons, 2014) book we use as a reference for our annual tax guide, identified 25 sources of tax-free income. Some are covered in our tax guide. There are, however, also sources that are less obvious or whose tax treatment may be less understood.

Inheritances: The estate of the deceased individual pays the federal estate tax. Heirs are do not pay taxes on the property or assets they inherit, but may be liable for taxes on any capital appreciation that occurs on inherited property that is sold. Inherited IRAs are subject to special tax rules.

Life Insurance Proceeds: Benefits paid following the death of the insured individual are not taxable. J.K. Lasser says no dollar limit on these payments exists.

Disability Payments: If you pay premiums for disability insurance, any compensation you receive for claims filed are tax-free as long as you paid the premiums yourself. If your employer pays the premiums as a benefit, then the payments are taxable. This rule applies specifically to disability insurance and not Social Security.

Insurance Claims: Claims made on a medical or auto policy for personal illness, injury or property damage are tax-free.

The Sale of a House: Married couples filing jointly can exclude up to $500,000 of capital gains from the sale of a house. Certain restrictions apply, particularly a requirement that the sellers not only lived in the house, but also used it as their primary residence for at least two of the five years preceding the date of the sale.

Coupons, Rebates and Frequent Flyer Miles: None of these benefits are taxable, so take advantage of them. J.K. Lasser says the tax code treats coupons and rebates as an adjustment to the purchase price. Frequent flyer miles are not taxable as long as they cannot be redeemed for cash. (Bankrate.com says credit card rewards are also tax-free so long as a transaction is required to earn them.)

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